Market downturns can come out of nowhere. That’s where options, especially put options, come into play. They can act as a safety net, helping you protect your portfolio when the markets turn choppy.
What Are Put Options, and Why Use Them for Protection?
A put option gives you the right (but not the obligation) to sell a stock or an index at a predetermined price, called the strike price, before the option expires. During market downturns, the value of put options typically rises, potentially mitigating a portion of portfolio losses.
According to TMX 1, put options serve two key roles: they’re a way to take advantage of a drop in stock prices, and they act as an insurance policy for bullish investors who have near-term concerns.
By owning puts, you’re essentially locking in a minimum value for your holdings. If the market stays steady or rises, you can let the puts expire and just lose the premium paid for the insurance, which is often a small price for peace of mind. If markets decline, however, they offer a level of mitigation for the losses experienced by the underlying asset.
When Should You Consider Buying Puts?
Buying puts isn’t something you necessarily want to do all the time, or for all the assets within your portfolio. Like any insurance, there are always costs to consider. But there are a few scenarios when puts might make sense.
Ahead of anticipated volatility
If you expect significant market uncertainty (e.g., earnings seasons, geopolitical tensions, or economic data releases), puts can provide downside protection. In asset classes with inherently elevated volatility, puts can also help dampen overall volatility and mitigate drawdowns for the period of the put contract.
When your portfolio is heavily concentrated
If your portfolio has large exposure to sectors or stocks vulnerable to short-term shocks, puts on those holdings or on a broad index can help cushion the blow.
After significant gains
Sometimes, after a strong rally, the market might be due for a correction. Buying puts can lock in some of your gains without having to sell your positions.
During risk-off environments
When broader economic indicators signal potential trouble ahead, adding put protection can reduce portfolio volatility.
1] Put Options: Now RRSP Eligible, https://www.m-x.ca/f_publications_en/options_put.pdf
How to Size Your Put Positions Responsibly
Sizing is critical. Buy too few puts, and you get limited protection; buy too many, and you’re paying excessive premiums that drag on your returns over time.
When buying put options for downside protection, the strike price and expiration date are important factors to consider because they affect both your level of protection and the cost.
A general rule of thumb is to hedge a portion of your portfolio based on your risk tolerance and market outlook.
Risks To Consider
Using put options for downside protection can be a savvy strategy for investors that want to stay bullish but safeguard against near-term risks. While puts can be a powerful tool, it’s important to be aware of the risks:
- Premium Cost: The price you pay for puts (the premium) can add up over time, especially if you frequently buy options that expire worthless. This can reduce overall portfolio returns if the protection isn’t needed.
- Expiration Risk: Options have a limited lifespan. If the market doesn’t move in your favor before the expiration date, the put expires worthless, and you lose the premium paid.
- Timing and Market Movements: Market drops might happen outside the time frame of your put option, or the price decline might be smaller than expected, limiting the put’s effectiveness.
- Complexity: Options trading requires understanding strike prices, expiration dates, implied volatility, and more. Without proper knowledge, it’s easy to misprice risk or buy protection that doesn’t fit your needs.
If the idea of trading options feels intimidating, that’s totally normal. The good news? Platforms like Qtrade offer powerful tools designed to help investors navigate options trading with confidence.
Using these tools can demystify options trading and help you make smarter, more informed decisions to protect your portfolio effectively.